A particular kind of uneasy quiet hangs over Britain. For decades, we have, fiscally speaking, relied on the “kindness of strangers” to keep us afloat. Yet, as public sector net debt hovers at a staggering 100% of GDP and growth has remained largely stagnant since the Global Financial Crisis of 2008, we are now testing the limits of our credibility
At the Centre for a Better Britain, we have convened working groups from across the City, industry, and politics to address exactly why successive governments have failed to restore growth. It is clearly a question of mounting public concern; indeed, the Labour Government was partially elected on a narrative of breaking the cycle of stagnation, correctly identifying this as critical to improving living standards.
However, the Government must also wean itself off the kindness of strangers to finance its day-to-day spending. There has been much talk of Britain being “in hock” to the shadowy forces of the bond markets. The fact is that, by relying heavily on the international government bond market to keep the lights on, the UK has left itself vulnerable to a sudden “strike” by bond investors — a so-called sovereign debt crisis.
Both the growth and debt challenges are existential, with the former being critical to escaping from the latter: a massive and growing debt pile that also includes the off-balance sheet and inflation-linked public sector pension liabilities, roughly equal the size of the official National Debt.
A sovereign debt crisis occurs when a country’s public debt can no longer be financed through the usual primary debt markets. At this stage, investors stop believing a country’s debt is creditworthy, or the interest rates required to attract buyers become so high they necessitate even more borrowing, creating a debt spiral.
Notwithstanding potential political developments in the UK this year, a Truss-style loss in confidence is not likely imminent, and it would be irresponsible to fear-monger.
That said, recent volatility in international bond markets — including that seen in Japanese government bonds — combined with a deteriorating global perception of Britain as a stable jurisdiction, mean this is not an entirely theoretical event. Moreover the UK, which runs both consistently high fiscal and current account (trade) deficits, is structurally vulnerable, with natural demand for UK government bonds (gilts) declining as domestic pension funds roll off their holdings.
From a risk management perspective even a moderate likelihood of a debt crisis — combined with what would be catastrophic ramifications — necessitates a response plan. It is for this reason we ran a series of working groups on this subject, with our recommendations published last November, detailing how the Government must respond if the markets decide to strike.
A crisis could be triggered by any number of events: a significant deviation from the Chancellor’s “fiscal rule”, a credit rating downgrade, a failed gilt auction, or even a “black swan” geopolitical shock. The risk of a less fiscally prudent administration following a change in political leadership should not be discounted by investors, either.
When a government can no longer meet its cash flow requirements on affordable terms, it can face a choice between drastic fiscal policy changes or approaching creditors to restructure debt. The UK has been here before: in 1976, the Labour Government was forced to seek a $3.9 billion loan from the IMF after a collapse in sterling and a loss of market confidence.
In a crisis, the number one objective is to restore bond market credibility — and, crucially, not to make things worse. To do this, the government must convince the market of three things:
- Public spending can be credibly cut back
- Growth can support future tax receipts
- The value of gilts won’t be undermined by inflation or a sterling collapse (noting that a third of gilt holders are foreign)
Spending cuts need not be drastic if supported by monetary policy and presented as part of a wider structural reform package. First and foremost, a credible plan must be politically executable. While we cannot predict the exact severity of any future crisis, we estimate that immediate cuts totaling a relatively modest 2-3% of Total Managed Expenditure (TME) would likely suffice to signal intent to the markets. However, this is likely to only be effective with institutional support — primarily the Bank of England standing ready as a “Market Maker of Last Resort” to ensure orderly gilt market function and provide temporary liquidity.
A plan to restore market trust also requires a roadmap for long-term fiscal sustainability. This means tackling longer term liabilities such as the “triple lock” on pensions and reforming vast, unfunded public sector liabilities, whilst introducing the fundamental structural reforms needed to reestablish a growth trajectory — the latter being the focus of our current working groups.
With regards to where savings could be made, our “menu” focuses on resetting items that spiraled out of control during and after the pandemic — for example, reducing the civil service headcount to 2019 levels, revising welfare eligibility criteria back to 2019 benchmarks and bringing train operating company (TOC) subsidies back to 2019 levels. All constitute defensible benchmarks likely to command public understanding and consent. Moreover, stopping the “active” sales of gilts on the Bank’s balance sheet alone could save the Treasury over £10bn annually in the short term.
The UK cannot credibly rely on tax hikes
While tax rises are a traditional and normally effective emergency response to a sovereign debt crisis, the UK’s problem is not a lack of revenue — it is an excess of spending and an absence of growth. With the tax burden already at a post-war high, further increases would likely be counter-productive, discouraging essential investment and consumption. While the Chancellor would nevertheless have to retain the flexibility to raise VAT or income tax, we would argue this should only be used as a very last resort.
The most pressing political question is whether this Labour Government would be prepared to do what is necessary? While the Labour Government of James Callaghan and Denis Healey eventually took the medicine prescribed by the IMF in 1976, we fear that the current Labour Government, which has rejected “austerity” of the past, would be unwilling to introduce the measures as outlined above. There is plenty of evidence for this already; when attempting to address a “black hole” in the public finances, the Government had to abandon relatively modest welfare reforms in the face of a rebellion from its own MPs.
If the Government delays or dilutes necessary fiscal measures during a crisis — or the Bank of England strays too far into fiscal dominance to effectively monetise the deficit — the situation could deteriorate rapidly, with mass capital flight, sterling depreciation, and even the unthinkable prospect of a sovereign debt restructuring as plausible outcomes. This would devastate household wealth and pensions, likely triggering civil unrest and an early General Election.
The Eurozone crisis of 2012 provides a warning of how quickly these dynamics can materialise when a government loses the “kindness of strangers”. Furthermore, an IMF loan today is not a guaranteed safety net, given the scale of funds required to stabilise a G7 economy like the UK.
The UK situation is fixable, however the Government should proactively introduce immediate reforms
All this being said, the UK is not Greece in 2012 — yet. The situation is fixable, but it requires a level of political courage that has been absent for decades. The UK cannot tax its way out of its debt spiral, nor can it borrow its way to growth. It must be prepared to implement a roadmap of immediate savings and structural pro-growth reforms — now. The alternative is to wait for the markets to force its hand. A failure to act risks a slow-motion (or indeed sudden) slide back into the “doom loop” that defined the 1970s, with the UK emerging, once again, as the “sick man of Europe”.
